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Twelfth Federal Reserve District
FedViews
August 14, 2014
Economic Research Department
Federal Reserve Bank of San Francisco
101 Market Street
San Francisco, CA 94105
Also available upon release at
http://www.frbsf.org/economic-research/publications/fedviews/
Michael Bauer, economist at the Federal Reserve Bank of San Francisco, states his views on the current
economy and the outlook.

Real GDP rebounded strongly in the second quarter of 2014, as expected. This followed an
anomalous dip in the first quarter caused mainly by transitory factors such as unusually severe winter
weather. The increase in real output was broad-based, with gains in consumer spending, investment,
government expenditures, and exports. We expect steady growth through 2015, at an average annual
rate slightly above 3%.

Conditions in labor markets have improved further, also in line with our expectations. The
unemployment rate continued its downward trend throughout the first part of the year. A slight uptick
in July was due to an increase in the number of people starting to look for jobs again, that is,
increasing labor market participation, which we see as a positive sign. Strong job creation has been
another encouraging sign that the labor market is healing. Despite these improvements, which we
expect to continue, other indicators suggest there is still a significant amount of slack in the labor
market. Importantly, wage growth remains subdued, indicating that the economy is not yet close to
full employment.

Broader trends in inflation suggest it is gradually approaching the Federal Open Market Committee’s
long-run objective of 2%. Inflation data in the second quarter came in slightly higher than earlier in
the year, but most of the increases were in categories with volatile prices. As a result, these numbers
probably overstate the true rate somewhat. Hence we expect inflation to moderate in the second half
of this year and then gradually increase toward levels consistent with the FOMC’s objective.

Financial conditions have been highly supportive of continued growth in the economy. In particular,
long-term interest rates receded over the first half of this year, which should further encourage
consumer spending, the recovery in the housing market, and business investment.

The stability of the financial system is fundamental for a healthy, growing economy. One aspect of
financial stability is the soundness of asset markets, reflected in indicators such as valuations,
volatility of market prices, and investor leverage. Recently, there have been concerns about the
stability in some equity and bond markets. Valuations in certain segments of equity markets appear
stretched relative to fundamentals. And in the market for risky corporate debt—the high-yield bond
The views expressed are those of the author, with input from the forecasting staff of the Federal Reserve Bank of San Francisco. They are
not intended to represent the views of others within the Bank or within the Federal Reserve System. FedViews generally appears around
the middle of the month. The next FedViews is scheduled to be released on or before September 19, 2014.
market—spreads of interest rates over those of safe Treasury bonds have been very low relative to the
historical average.

Importantly, volatility in equity markets has been near historically low levels as indicated by the level
of the VIX, an index that measures the volatility of Standard & Poor’s 500 equity index using option
prices. It is sometimes nicknamed the “investor fear gauge” since it reflects the anxiety of equity
investors. Currently, the VIX is well below its historical average. One interpretation is that investors
have not been very worried about risks to the economic outlook. The picture is similar in bond
markets, where volatility is currently quite low as well.

This low volatility environment contrasts with significant risks to the economic outlook, such as
geopolitical turmoil in the Middle East, a potential property bust in China, and deflation and
stagnation in Europe, to name a few. Investors currently appear to be complacent about these risks.

This apparent investor complacency could result in abrupt reversals of financial asset prices and
spikes in volatility in response to unexpected developments. However, we believe that such changes
in asset prices would not substantially tighten overall financial conditions and therefore should have
only limited effects on the economy.

The reason is that, overall, the financial system appears to be on solid footing. For example, banks’
capital ratios have improved, the degree of leverage in the financial sector is relatively low, and there
is ample liquidity available in the system. Still, although we are not overly concerned about the low
volatility environment in financial markets at this time, we will continue to carefully monitor the
health of asset markets for signs of distress.
Unemployment gradually declining
GDP rebounds from first quarter dip
GDP growth: actual and FRBSF forecast
%
Quarterly percent change at seasonally adjusted annual rate
Unemployment rate and forecast
%
Seasonally adjusted monthly observations, forecast is quarterly average
12
6
Q2
10
2
Jul
6.2
Unemployment rate
FRBSF
forecast
Actual
8
-2
6
FRBSF forecast
4
-6
2
2007
2008
2009
2010
2011
2012
2013
2014
2015
-10
2007
Source: Bureau of Economic Analysis and FRBSF staff
2008
2009
2010
2011
2012
Source: Bureau of Labor Statistics and FRBSF staff
Very strong job growth this year
Nonfarm payroll employment
2014
2015
400
%
Percent change from 4 quarters earlier
5
350
4
Jul
Monthly
change
0
Inflation gradually returning to target
PCE price inflation
Thousands
Seasonally adjusted monthly observations
2013
Overall PCE
price index
300
6-month moving
average
3
250
2
200
FRBSF
150
Q2 forecasts
Core PCE
price index
0
100
-1
50
2011
2012
2013
2014
0
1
2007
2008
2009
2010
2011
2012
2013
2014
2015
-2
Source: Bureau of Economic Analysis and FRBSF staff
Source: Bureau of Labor Statistics
Equity volatility near historical low
Long-term yields have edged down
Interest rates
%
Weekly average
8
Implied volatility for the S&P 500
Index
Daily VIX
90
80
7
30-year mortgage
70
6
60
5
50
4
40
10-year Treasury
3
30
2
Federal funds rate
2-year Treasury
2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014
Source: FAME
20
1
0
10
2005
2006
2007
Source: Bloomberg
2008
2009
2010
2011
2012
2013
2014
0